Unitholders of Manulife US Reit caught between a rock and a hard place

A LIFELINE was thrown to Manulife US Real Estate Investment Trust (MUST) last week, some four months after the Reit breached financial covenants.

The rescue package – in the form of a three-part recapitalisation plan that entails selling assets and taking a loan from its sponsor – provides MUST with a longer timeline to navigate out of its current troubles.

It is logical for unitholders to vote in favour of the recapitalisation plan at the upcoming extraordinary general meeting (EGM), but investors are still caught between two unpalatable situations.

The recapitalisation plan certainly beats a disorderly liquidation of the portfolio in a weak US office market, which could leave unitholders with nothing. But equity holders still face uncertainty over the value that could be realised in the longer term.

For most Reit investors who typically seek regular dividend income, a key question would be whether the risk is worth the reward, in view of other potentially attractive opportunities also available in the market.

Getting stuck

MUST’s current woes started in July, when its portfolio valuations fell 14.6 per cent. This caused the Reit to breach its existing financial covenants, and affected its ability to pay out distributions.

The Reit’s proportion of unencumbered debt to unencumbered assets exceeded the 60 per cent threshold, and its aggregate leverage crossed the 50 per cent regulatory gearing limit.

This left the Reit in a tough situation with few good options remaining. But the recapitalisation plan announced last week provided a glimmer of hope.

The Reit is receiving financing from its sponsor – with US$137 million in loans – at a time when few lenders are willing to extend credit. The loan, together with the asset sale of Park Place in Arizona to the sponsor, and utilisation of some of US$50 million in MUST’s cash holdings, would help pay down the US$285 million in outstanding debt on a pari passu basis, reducing lenders’ exposure.

The deal also buys the Reit time, as its weighted average debt maturity is now at 3.7 years, up from 2.3 years, with the earliest expiry in 2025. This gives the Reit a 19-month runway to execute asset dispositions.

Compared to a disorderly liquidation in the current unfavourable US office market, the recap plan appears sound.

MUST does not have to immediately face the risk of lenders accelerating the payment of its US$1 billion in loans, which could result in liquidation of the portfolio at distressed prices.

But unitholders were still unenthusiastic. The counter plunged by almost 43 per cent the following trading day to US$0.052.

Selling action was also heavy, with over 100 million units being traded; this was more than 10 times the average daily volume in the past year.

The counter rallied in November, as investors anticipated “a holistic sponsor package that would address MUST’s longer-term liquidity needs and provide financial flexibility”. But clearly, the deal fell short of expectations.

Uncertainties

A key issue for investors was likely the significant uncertainty over the value that could eventually be realised.

For one, half-yearly distributions remain suspended until December 2025, unless the Reit achieves “early reinstatement conditions”, which are similar to the regulatory leverage limits in Singapore.

Meanwhile, the Reit has conducted a portfolio analysis, and is seeking to sell off less desirable “Tranche 1” assets that have higher occupancy risks and capital expenditure requirements in return for lower total potential return.

While the strategy is sound, the Reit is selling off such assets in a weak US office market, meaning that they are probably less attractive to many buyers.

MUST has noted that a key issue is that debt markets currently lack liquidity, and buyers who have cash now are currently bargain hunting. Buying more time for the normalisation of debt markets could result in a normalised transaction market.

But there are still execution risks, given that the US office market is facing structural challenges from changing work patterns post-pandemic.

The sponsor also has not acquired an asset from Tranche 1. Instead, Park Place would have been ranked in a higher tranche, which has lower occupancy risks, and better return potential.

It was noted that the sponsor operates in a heavily regulated industry, with its own shareholders to answer to. Indeed, it may not be realistic to expect the sponsor to table a rescue deal that would fully bail out unitholders.

But it is likely that investors were not expecting the sponsor’s support to come at such a high price. The sponsor’s loan extended to MUST comes at an effective interest rate of 10 per cent per annum.

While this has been assessed to be on “normal commercial terms” by the independent financial adviser, unitholders would probably have preferred that the sponsor support showed more skin in the game.

Debt investments at a fixed rate of return provide greater certainty compared to equity holders, who face halted distributions.

In the longer term, investors could also face further equity fundraising rounds in future.

The recapitalisation plan gives MUST a chance to eventually recover, but the uncertainty over the next two years makes it a tough proposition for income-seeking Reit investors to stay on.

Dozens of other Reits in the Singapore market are also trading at discounted valuations amid the high interest rate environment.

Bloomberg data shows that the sector has an average price-to-book ratio of 0.8, with a median trailing distribution yield of nearly 7 per cent. Many counters also provide opportunities for upside, based on analysts’ target prices, without this much uncertainty.

Analysts have expressed a preference for counters in the retail and hospitality sub-sectors. Switching to counters with strong balance sheets and supportive sponsors may prove to be a more rewarding play in the longer term.